Friday, January 25, 2013

Simon Wren-Lewis argues that the "crisis view" of change in macroeconomic
theory is too simple

Misinterpreting the history of macroeconomic thought, mainly macro: An
attractive way to give a broad sweep over the history of macroeconomic ideas
is to talk about a series of reactions to crises (see
Matthew Klein and
Noah Smith). However it is too simple, and misleads as a result. The
Great Depression led to Keynesian economics. So far so good. The inflation
of the 1970s led to ? Monetarism - well maybe in terms of a few brief policy
experiments in the early 1980s, but Monetarist-Keynesian debates were going
strong before the 1970s. The New Classical revolution? Well rational
expectations can be helpful in adapting the Phillips curve to explain what
happened in the 1970s, but I’m not sure that was the main reason why the
idea was so rapidly adopted. The New Classical revolution was much more than
rational expectations.

The attempt gets really off beam if we try and suggest that the rise of RBC
models was a response to the inflation of the 1970s. I guess you could argue
that the policy failures of the 1970s were an example of the Lucas critique,
and that to avoid similar mistakes macroeconomists needed to develop
microfounded models. But if explaining the last crisis really was the prime
motivation, would you develop models in which there was no Phillips curve,
and which made no attempt to explain the inflation of the 1970s (or indeed,
the previous crisis - the Great Depression)?

What the ‘macroeconomic ideas develop as a response to crises’ story leaves
out is the rest of economics, and ideology. The Keynesian revolution (by
which I mean macroeconomics after the second world war) can be seen as a
methodological revolution. Models were informed by theory, but their
equations were built to explain the data. Time series econometrics played an
essential role. However this appeared to be different from how other areas
of the discipline worked. In these other areas of economics, explaining
behavior in terms of optimization by individual agents was all important.
This created a tension, and a major divide within economics as a whole.
Macro appeared quite different from micro.

A particular manifestation of this was the constant question: where is the
source of the market failure that gives rise to the business cycle. Most
macroeconomists replied sticky prices, but this prompted the follow up
question: why do rational firms or workers choose not to change their
prices? The way most macroeconomists at the time chose to answer this was
that expectations were slow to adjust. It was a disastrous choice, but I
suspect one that had very little to do with the nature of Keynesian theory,
and rather more to do with the analytical convenience of adaptive
expectations. Anyhow, that is another story.

The New Classical revolution was in part a response to that tension. In
methodological terms it was a counter revolution, trying to take
macroeconomics away from the econometricians, and bring it back to something
microeconomists could understand. Of course it could point to policy in the
1970s as justification, but I doubt that was the driving force. I also think
it is difficult to fully understand the New Classical revolution, and the
development of RBC models, without adding in some ideology.

Does this have anything to tell us about how macroeconomics will respond to
the Great Recession? I think it does. If you bought the ‘responding to the
last crisis’ narrative, you would expect to see some sea change, akin to
Keynesian economics or the New Classical revolution. I suspect you would be
disappointed. While I see plenty of financial frictions being added to DSGE
models, I do not see any significant body of macroeconomists wanting to ply
their trade in a radically different way. If this crisis is going to
generate a new revolution in macroeconomics, where are the revolutionaries?
However, if you read the history of macro thought the way I do, then macro
crises are neither necessary nor sufficient for revolutions in macro
thought. Perhaps there was only one real revolution, and we have been
adjusting to the tensions that created ever since.

Let me follow up on the ideological point with an example. Prior to the New
Classical revolution in the 1970s (which, contra some recent descriptions, is
different from DSGE models), the people who do not believe that government
intervention is bad had a problem. It was very clear in the data that there was
a positive correlation between changes in the money supply and changes in
employment and real income. Further, though this is harder to establish, the
relationship appeared causal. Money causes income, and this allowed government
to stabilize the economy.

The (neo)classical model, with its vertical AS curve, could not explain the
positive money-income correlation in the data. In the typical classical
formulation, so long as prices are perfectly flexible and all markets clear at
all points in time, the economy is always in long-run equilibrium. Thus, in
these models the prediction is a zero correlation between money and income. But
it wasn't zero.

However, a very clever idea from Robert Lucas in the 1970s allowed this
correlation to be explained without admitting government can do good, i.e.
without admitting that government can stabilize the economy using monetary
policy. This is the ideological part -- a way to explain the data without
acknowledging a role for government at the same time. I can't say that Lucas
approached the problem in this way, i.e. that he started out with the
ideological goal of explaining the money-income correlation without allowing a
role for government. Maybe it arose in a flash of brilliance completely
unconnected to ideological concerns, But I find it hard to explain why this
model came about in the form it did without ideology, and the view of government
the New Classical model supported surely didn't hurt its acceptance at places
like the University of Chicago (as it existed then).

Comments

You can follow this conversation by subscribing to the comment feed for this post.

'Misinterpreting the History of Macroeconomic Thought'

Simon Wren-Lewis argues that the "crisis view" of change in macroeconomic
theory is too simple

Misinterpreting the history of macroeconomic thought, mainly macro: An
attractive way to give a broad sweep over the history of macroeconomic ideas
is to talk about a series of reactions to crises (see
Matthew Klein and
Noah Smith). However it is too simple, and misleads as a result. The
Great Depression led to Keynesian economics. So far so good. The inflation
of the 1970s led to ? Monetarism - well maybe in terms of a few brief policy
experiments in the early 1980s, but Monetarist-Keynesian debates were going
strong before the 1970s. The New Classical revolution? Well rational
expectations can be helpful in adapting the Phillips curve to explain what
happened in the 1970s, but I’m not sure that was the main reason why the
idea was so rapidly adopted. The New Classical revolution was much more than
rational expectations.

The attempt gets really off beam if we try and suggest that the rise of RBC
models was a response to the inflation of the 1970s. I guess you could argue
that the policy failures of the 1970s were an example of the Lucas critique,
and that to avoid similar mistakes macroeconomists needed to develop
microfounded models. But if explaining the last crisis really was the prime
motivation, would you develop models in which there was no Phillips curve,
and which made no attempt to explain the inflation of the 1970s (or indeed,
the previous crisis - the Great Depression)?

What the ‘macroeconomic ideas develop as a response to crises’ story leaves
out is the rest of economics, and ideology. The Keynesian revolution (by
which I mean macroeconomics after the second world war) can be seen as a
methodological revolution. Models were informed by theory, but their
equations were built to explain the data. Time series econometrics played an
essential role. However this appeared to be different from how other areas
of the discipline worked. In these other areas of economics, explaining
behavior in terms of optimization by individual agents was all important.
This created a tension, and a major divide within economics as a whole.
Macro appeared quite different from micro.

A particular manifestation of this was the constant question: where is the
source of the market failure that gives rise to the business cycle. Most
macroeconomists replied sticky prices, but this prompted the follow up
question: why do rational firms or workers choose not to change their
prices? The way most macroeconomists at the time chose to answer this was
that expectations were slow to adjust. It was a disastrous choice, but I
suspect one that had very little to do with the nature of Keynesian theory,
and rather more to do with the analytical convenience of adaptive
expectations. Anyhow, that is another story.

The New Classical revolution was in part a response to that tension. In
methodological terms it was a counter revolution, trying to take
macroeconomics away from the econometricians, and bring it back to something
microeconomists could understand. Of course it could point to policy in the
1970s as justification, but I doubt that was the driving force. I also think
it is difficult to fully understand the New Classical revolution, and the
development of RBC models, without adding in some ideology.

Does this have anything to tell us about how macroeconomics will respond to
the Great Recession? I think it does. If you bought the ‘responding to the
last crisis’ narrative, you would expect to see some sea change, akin to
Keynesian economics or the New Classical revolution. I suspect you would be
disappointed. While I see plenty of financial frictions being added to DSGE
models, I do not see any significant body of macroeconomists wanting to ply
their trade in a radically different way. If this crisis is going to
generate a new revolution in macroeconomics, where are the revolutionaries?
However, if you read the history of macro thought the way I do, then macro
crises are neither necessary nor sufficient for revolutions in macro
thought. Perhaps there was only one real revolution, and we have been
adjusting to the tensions that created ever since.

Let me follow up on the ideological point with an example. Prior to the New
Classical revolution in the 1970s (which, contra some recent descriptions, is
different from DSGE models), the people who do not believe that government
intervention is bad had a problem. It was very clear in the data that there was
a positive correlation between changes in the money supply and changes in
employment and real income. Further, though this is harder to establish, the
relationship appeared causal. Money causes income, and this allowed government
to stabilize the economy.

The (neo)classical model, with its vertical AS curve, could not explain the
positive money-income correlation in the data. In the typical classical
formulation, so long as prices are perfectly flexible and all markets clear at
all points in time, the economy is always in long-run equilibrium. Thus, in
these models the prediction is a zero correlation between money and income. But
it wasn't zero.

However, a very clever idea from Robert Lucas in the 1970s allowed this
correlation to be explained without admitting government can do good, i.e.
without admitting that government can stabilize the economy using monetary
policy. This is the ideological part -- a way to explain the data without
acknowledging a role for government at the same time. I can't say that Lucas
approached the problem in this way, i.e. that he started out with the
ideological goal of explaining the money-income correlation without allowing a
role for government. Maybe it arose in a flash of brilliance completely
unconnected to ideological concerns, But I find it hard to explain why this
model came about in the form it did without ideology, and the view of government
the New Classical model supported surely didn't hurt its acceptance at places
like the University of Chicago (as it existed then).